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Alarm bells ring for the euro area

Posted on 11/03/2019

We were taken by surprise last week by the scale of the downgrade to the OECD’s latest forecast for German growth. The OECD now thinks that the German economy will grow by just 0.7% in 2019. This is a big reversal of fortune; a year ago the thinking among economists was that Germany would grow by around 2.0%. At 0.7% German growth would be slower than the euro area as a whole (1.0%) and even the Brexit-embattled UK (0.8%).

The slowdown in Germany and the euro area has come faster than expected, with activity slowing in the second half of 2018 and Germany narrowly avoiding a technical recession. The OECD expects the euro area as a whole to grow at the slowest rate since the euro crisis in 2012-13, with the Italian economy dipping into recession.

Alarm bells are going off in Europe – and there could be no clearer sign of this than last week’s dramatic reversal of policy by the European Central Bank (ECB). In December the Bank ended its quantitative easing programme of monetary stimulus. The message was that it was ‘mission accomplished’ for its eight-year campaign to boost growth. Last week the Bank executed a volte face, announcing more stimulus in the form of cheap loans to banks and a pledge to keep interest rates at zero through this year.

In recent years the German economy has boomed. Its export success, the quality of its vocational education system and its ‘mittelstand’ companies, are the envy of the world. So why has Germany seen such an abrupt change in its fortunes?

Part of the problem is that after years of strong growth Germany no longer has the people or the capacity to maintain growth. Unemployment is at the lowest level since the 1970s and 800,000 jobs are unfilled. A recent survey showed that almost half of businesses are turning down new orders. Unlike France or Italy, where unemployment is high and there is plenty of slack in the economy, Germany has simply run out of capacity.

Outsiders look at Germany’s export success and its huge current account surplus with admiration. As an export-focussed economy Germany has been able to lock into fast-growth emerging markets and benefit from the global upswing. But in a world of rising protectionism and slowing demand export dependence acts as a drag on growth. Last year German exports of goods and services grew by only 0.3%, far slower than the growth of the wider economy.

The pressures on Germany’s world-beating auto sector are particularly acute. The emissions scandal, and bans on older diesel vehicles in a number of German cities, led to a sharp fall in the output of diesel cars last year. Meanwhile a decline in Chinese car sales last year, the first in a quarter of a century, was a blow for German car makers that are heavily-dependent on the Chinese market.

A lack of spare capacity, a slowing global economy, protectionism and the emissions scandal – these are, one hopes, temporary challenges. But lurking beneath them is a much more profound change of a shrinking working-age population, which is predicted to shrink 8.8% by 2040.

The German economy has immense strengths and its recent performance has been outstanding. Its people are enjoying rising living standards and near record low unemployment. Germany has the distinction among major European nations of having run a surplus on its public finances for the last five years. Germany has indeed repaired its roof while the sun has shone.

Germany’s scale, its strength and its solvency mean that others see it as Europe’s spender of last resort as growth slows. Last week the OECD argued that Germany is well placed to boost demand at home and across the euro area by easing fiscal policy.

This argument has force given that monetary policy is, on some measures, looking close to exhausted. With rates at record lows there is little scope for further cuts. Additional quantitative easing is limited by rules which prevent the ECB from becoming a dominant lender to any country or from lending too much to highly indebted countries.

Certainly there are lots of useful ways in which Germany might spend its budget surplus. Germany’s legendary infrastructure, particularly roads and bridges, are in need of fresh investment. The country spends less as a share of GDP on education than France and the UK. Against a backdrop of a growing threat from Russia, Germany’s armed forces look distinctly underpowered.

Yet Germany seems as averse to running budget deficits as it is to inflation. The political culture in Germany is one of prudence, not Keynesian-style deficit-financing. As finance minister Olaf Schulz said last month, “The clear precondition of all government budgetary planning is that we achieve a balanced budget, without new debts.”

If the euro area downturn gathers pace the clamour for Germany to spend more, and act as an engine for growth, is likely to increase. As the euro crisis showed, it is at such times that the preferences of different member states conflict.

PS: Last week we wrote about how bubbles in asset markets form and the fact that financial crises tend to be proceeded by credit booms. One such boom has been in leveraged lending which is now a significant source of capital for less creditworthy companies. Last Thursday the Financial Stability Board, a global regulator, launched an investigation into parts of the $1.4 trillion global leveraged loan market, citing potential financial stability risks.

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